Inferring the forward looking equity risk premium from derivative prices

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Show simple item record Bhar, Ramaprasad en_US Chiarella, Carl en_US Runggaldier, Wolfgang en_US 2009-12-21T03:50:45Z 2009-12-21T03:50:45Z 2004 en_US
dc.identifier 2004000203 en_US
dc.identifier.citation Bhar Ramaprasad, Chiarella Carl, and Runggaldier Wolfgang 2004, 'Inferring the forward looking equity risk premium from derivative prices', Berkeley Electronic Press, vol. 8, no. 1, pp. 1-24. en_US
dc.identifier.issn 1081-1826 en_US
dc.identifier.other C1 en_US
dc.description.abstract This paper considers the measurement of the equity risk premium in financial markets from a new perspective that picks up on a suggestion from Merton (1980) to use implied volatility of options on a market portfolio as a direct 'ex-ante' estimate for market variance, and hence the risk premium. Here the time variation of the unobserved risk premium is modelled by a system of stochastic differential equations connected by arbitrage arguments between the spot equity market, the index futures and options on index futures. We motivate and analyse a mean-reverting form for the dynamics of the risk premium. Since the risk premium is not directly observable, information about its time varying conditional distribution is extracted using an unobserved component state space formulation of the system and Kalman filtering methodology. In order to cater for the time variation of volatility we use the option implied volatility in the dynamic equations for the index and its derivatives. This quantity is in a sense treated as a signal that impounds the market's 'ex-ante', forward looking, view on the equity risk premium. The results using monthly U.S. market data over the period January 1995 to June 2003 are presented and the model fit is found to be statistically significant using a number of measures. Comparisons with ex-post returns indicate that such historical measures may be understating the market risk premium. en_US
dc.publisher Berkeley Electronic Press en_US
dc.title Inferring the forward looking equity risk premium from derivative prices en_US
dc.parent Studies in NonLinear Dynamics and Econometrics en_US
dc.journal.volume 8 en_US
dc.journal.number 1 en_US
dc.publocation Berkeley, USA en_US
dc.identifier.startpage 1 en_US
dc.identifier.endpage 24 en_US BUS.School of Finance and Economics en_US
dc.conference Verified OK en_US
dc.for 140300 en_US
dc.personcode 940554 en_US
dc.personcode 716350 en_US
dc.personcode 0000018062 en_US
dc.percentage 100 en_US Econometrics en_US
dc.classification.type FOR-08 en_US

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